Topic 2: Key concepts in the valuation of financial instruments Flashcards
(24 cards)
What is a financial instrument?
A claim on future cash flows like dividends
Why do we value financial instruments?
To figure out what future payments are worth today.
What is the main idea behind valuation?
Future cash is less valuable than cash today.
Why is a euro today worth more than a euro in the future?
You could use or invest the money now, there’s uncertainty in waiting, people generally prefer immediate rewards.
What types of financial instruments involve future cash flows?
Equities
What does equity provide?
Dividends and the potential to sell the share for profit.
What does a bond provide?
Regular interest payments and full repayment at the end of the term.
What is a discount bond?
A bond that pays a single amount at maturity
What is a perpetual bond?
A bond that pays regular coupons forever
What affects the value of a future cash flow?
The amount you expect to receive, the time you’ll have to wait, the risk of not getting paid, how urgently you or the market wants money now vs. later.
What is a discount rate?
A rate used to reflect how much less future cash is worth today.
What determines the discount rate?
A typical interest rate (like the bank deposit rate) , how risky the investment is (higher risk = higher rate) , how impatient someone is for money now
How do market prices help with valuation?
They let you compare what you think something is worth to what others are paying.
What does it mean if the market price is lower than your valuation?
The asset might be undervalued and worth buying.
What does it mean if the market price is higher than your valuation?
The asset might be overvalued and worth selling.
What is the implied return or yield?
The return the market expects based on price and future payments.
Why do interest rates matter to asset prices?
They affect how attractive future payments are compared to money now.
What happens to asset values when interest rates fall?
They usually rise
What happens to asset values when interest rates rise?
They often fall
How do lower interest rates affect borrowing and prices?
They make borrowing cheaper
What does it mean to discount a future payment?
To adjust its value to reflect the fact that it’s received in the future.
Why is it important to understand valuation?
It helps explain how prices are set in financial markets and why they change.
How do investors use valuation?
To decide whether to buy
What does the internal rate of return (IRR) represent conceptually?
The return that matches an asset’s future payments to its current price.
